Monday, September 5, 2011

One more follow-up to a series of posts on this subject, as it relates to the problems in Europe. The issue is the surge in the M2 measure of money supply, which is up $483 billion in the past 10 weeks, which works out to an annualized growth rate of 31%. As any monetarist would tell you, a monetary expansion of that magnitude, if continued, could spell real trouble in the form of much higher inflation down the road. However, if the extra growth in the money supply results from extra demand for money, then this is not an inflationary problem we are looking at, but rather a reflection of some other problem that is driving people to increase their holdings of dollar liquidity. (Inflation happens when the supply of money exceeds the demand for it; if strong money growth is driven by strong demand, then it is not necessarily inflationary.) As I detail below, it appears that the rapid expansion of M2 in recent months is part of the fallout of the eurozone sovereign debt crisis that is in full bloom. Money is fleeing Europe and seeking safety in the U.S.

To begin, this chart puts the growth of M2 in a long-term perspective. Since 1995, M2 has been growing about 6% per year. That works out to about $10 billion a week. So the extra growth over the past few months in M2 now totals almost $400 billion. That amount of growth in such a short time is unprecedented, so it must mean that there is something big going on that is creating a huge and rather sudden demand for dollar liquidity. My guess is that it is the problems in the Eurozone that have caused money to seek a safe haven in the U.S. banking system.

As the first chart above shows, eurozone swap spreads started rising right around the middle of June, which is also when M2 started its surge. Since eurozone 2-yr swap spreads are now 97 bps—a level exceeded only during the depths of the global financial crisis in the fourth quarter of 2008—there is little doubt that European banks are in the midst of a funding/liquidity crisis. Soaring swap spreads reflect soaring counterpart risk that stems from banks' exposure to the sovereign debt of PIIGS. It is noteworthy that U.S. 2-yr swap spreads currently are only 35 bps, a level that might be considered only slightly above normal. The problem so far is isolated to Europe, and that's good.

As this next chart shows, the biggest problem in the PIIGS world is Greece, where 2-yr government yields have soared to over 50%; 1-year Greek debt today is trading at an astonishing 80%. Clearly, no one wants to lend Greece money, and everyone fears that the now-inevitable Greek default will not only wipe out lots of bank capital, but might also lead to other PIIGS defaulting, and if that snowball started rolling downhill it could get big and scary very quickly. Swap spreads of almost 100 bps mean that everyone is very afraid of lending money, or having exposure, to the eurozone banks as well. It stands to reason that Eurozone depositors would prefer the relative safety of a U.S. bank deposit to that of a Eurozone bank.

Back to the subject of the U.S. money supply. The first chart above shows the $1.6 trillion increase in bank reserves that has resulted from two rounds of quantitative easing by the Fed. The second chart shows that of the $1.7 trillion in outstanding bank reserves, only about $80 billion are actually required to support the current level of deposits in the banking system; the rest are held as "excess" reserves at the Fed, where they currently earn 0.25% per year. Banks are apparently content to hold a huge amount of money in a "safe" form at the Fed, rather than using those reserves to support new lending. Nevertheless, it's interesting to see that required reserves have been increasing rather dramatically since quantitative easing began, after being relatively stagnant for over 20 years. U.S. money growth is not solely due to the problems in Europe; banks are returning to the business of lending, as shown in the next chart of C&I Loans, which are up at a 10% annualized rate in the past six months.

Swap spreads are telling us that main source of the world's fears these days is to be found in the Eurozone sovereign debt crisis. That explains why the European Stoxx 50 index is down over 30% from its February highs, while the S&P 500 is down only 15% or so from its April highs. It also explains why the Euro has fallen 5% against the dollar since its February highs, and 12% against the yen and 16% against the Swiss franc since its April highs. U.S. markets have been upset over some disappointing economic data in recent months, but the real reason markets are in a swoon is Europe.

Fixing Europe's problems shouldn't be all that hard in theory, but places like Greece have become addicted to Big Government and they are fighting hard to resist the austerity measures that are inevitable but politically hazardous. (The U.S. has the same problem, although we have yet to reach the crisis stage that Europe has.) Markets are already hard at work forcing a solution on Greece, since it obviously cannot continue to borrow money that costs upwards of 50-80% a year. Hard-working countries like Germany only postpone the day of reckoning by offering to bail Greece out, but even there the electorate is rapidly souring on the idea of working harder so the Greeks can work less. Ireland has made great strides, however, by choosing to slash spending while keeping taxes low.

Markets are apparently thinking that the intransigents like Greece will prevail, and that the world as we know it will collapse, as dominoes fall one by one beginning in Greece and ending in Spain, and that once the dust has settled, the Eurozone banking system will be vaporized and the global economy will be dealt a devastating blow. I can't say this is impossible, but if anything less dire than this actually happens, then it could prove to be good news.

It is 'all about Europe'. So what I want to know is not what happens at the end-of-the-world-as-we-know-it but when Greek debt defaults, then Italy, then European banks go under, Spain/Portugal, then the Euro...

I'm aware of the Reg Q argument, but the magnitude and the timing of the increase in M2 aligns so closely with the rise in swap spreads in Europe that it doesn't appear coincidental. Also, I don't see how banks could attract huge inflows based on their extremely limited ability to pay interest on checking accounts. (Reg Q is no longer in effect, which means banks can once again pay interest on checking accounts). After all, some banks are now charging for large deposits. Also, about two thirds of the rise in M2 has come in the form of savings deposits which are not affected by the end of Reg Q.

Inflows to M2 from Europe don't necessarily require a decline in European M2. For one, the ECB is purchasing large amounts of PIIGS debt, and that is undoubtedly creating new money. Two, money could be leaving euro CDs (not in M2) in favor of U.S. checking or savings accounts.

Thanks for responding to my comment. Eurozone M3 - including CDs - isn't contracting either. The ECB has bought only €55 billion of PIIGS bonds since it restarted intervention last month. If it buys from banks there is no first-round monetary impact. The suggestion of huge capital flight seems inconsistent with recent stability of the euro exchange rate.